This application is related, generally and in various embodiments, to enhanced financial methods, products, and systems for managing fixed income portfolios. Alpha refers to the deviation of the return that an active investment manager can generate compared with the passive return of the asset class exposure of the manager's portfolio. For example, the alpha of an equity manager (e.g., stock manager) with an S&P 500 beta of 1.0 would be the net return after fees of the manager's portfolio above or below the return of the S&P 500. The alpha of a fixed income manager (e.g., bond manager) would be the net return above or below a relevant benchmark (e.g. the Lehman Aggregate Index).
Portable alpha in the context of this application refers to a combination of a direct or derivative investment in a portfolio designed specifically to generate alpha with low levels of embedded stock and bond exposures (an “alpha engine”) and a direct or derivative investment in a portfolio designed to generate fixed income exposures that together with those embedded in the alpha engine will equal the fixed income characteristics specified by a client. This combination of an alpha engine and investments designed for fixed income exposures is expected to generate higher average returns over time than would be expected from an investment only in a traditional fixed income portfolio having the characteristics specified by a client.
A swap (e.g., total return swap) refers to a bilateral financial contract where a party agrees to make periodic payments, usually based on the London Inter-Bank Offered Rate (“LIBOR”) plus some premium, to a counter-party in return for receiving the total economic performance of a specified asset at the end of the swap. The total economic performance generally is the sum of interest, dividends and other income and the change in value (i.e. appreciation or depreciation) of the underlying asset. A swap allows an investor to receive the economic exposure of asset ownership at a cost of only some premium above LIBOR without a substantial capital outlay. Swap counter-party risk can be limited by diversification with high quality counter-parties and by settling swaps prior to expiration if the accrued receivables from counter-parties become large.
Asset-liability matching refers to the degree to which an increase or decrease in the liabilities of a pension fund, insurance company, or other institutional investor due to market conditions is offset by an increase or decrease in the value of their assets. For example, a decrease in interest rates typically would increase the projected benefit obligation (PBO) of a pension fund as reported in their financial statements but could be offset to some degree by an increase in the value of fixed income assets in the fund.
Spending rule benefits refers to the ability of an investment program to deliver relatively consistent returns that help an endowment, foundation or other institutional investor with specified annual spending needs to achieve returns consistent with such needs.
Portfolios of certain types of alternative investments, such as a fund-of-funds (e.g., a low volatility fund of hedge funds), can generate high alpha with only small amounts of embedded equity and fixed income exposures.
Institutional investors often can be characterized as either seeking higher return and/or alpha by increasing their allocations to equities or other expected high return, high risk asset classes (e.g., venture capital) at the expense of risk, or seeking better asset-liability matching and/or spending rule benefits by increasing their allocations to fixed income at the expense of expected return and/or alpha. Many such investors believe that the expected return of equities is higher than that of fixed income. Many also believe that a higher alpha can be generated from equity managers than from fixed income managers even though equities cannot be relied upon for asset-liability matching or spending rule benefits.
Because many institutional investors believe that the long-term expected absolute returns of fixed income classes are lower than for equities or other expected high return, high risk assets classes, they often will tend to allocate less to fixed income classes and more to equities or other expected high return, high risk assets classes.
After selecting asset classes an institutional investor often will seek traditional equity and fixed income managers to generate excess returns from the stock and fixed income allocations. It is quite difficult, however, to find traditional investment managers who will significantly outperform indices like the S&P 500 or various Lehman fixed income indices over long periods of time. Traditional stock and fixed income managers typically are investing in very efficient markets, tend to have long-only securities, and tend to stay very close to their benchmark. As such, there is limited opportunity to generate alpha.
Accordingly, there exists a need for enhanced financial methods, products, and systems for managing fixed income portfolios that seek higher returns, higher alpha, better asset-liability matching, and/or better spending rule benefits.